Friday fundamentals webinar: Getting the most from investing in LICs

-- | 27/05/2019

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Lex Hall: You probably remember that we spoke about exchange-traded funds or ETFs. There are some similarities that a lot of people will know about. There are also some differences and that's what we're going to go over today. We've had a lot of inquiries from you guys already. Please send us your questions, your comments, anything you want to know about LICs, exchange-traded funds. We'll answer them. And if we don't today, we'll get to your questions offline. So, we want to keep the conversation going.

Tony, for example, has written in and he wants to know about the pros and cons of LICs. We'll talk about that. Barbara is interested in LICs and franking credits. Barb, you don't need to worry about franking credits anymore because the election has been run and won and I think franking credits will be on the backburner for probably about six years or so. And if Labor do get in, they are maybe hesitant about touching them again. So, don't worry about that. John wants to know if LICs have better place than banks to park your money. That's a good question. We've also got a question from Basil in WA, which is an interesting one. So, stay with us over the next 15 minutes. We'll try to answer all your questions. But send them through, as we said, and your comments and we will try and respond to them.

We're going to discuss today LICs, what they are, what they invest in, how they work, more importantly, how you can buy them and of course, we're going to talk about the risk, because it is investing, so there's always risks involved. But I'd like to introduce you to Andrew Miles first of all.

Andrew, good day.

Andrew Miles: Good day, Lex.

Hall: Now, LICs, what are they? My understanding is they are – a company is created, and they invest in another bunch of companies and you can buy into that company, if you like? Is that a fair summation?

Miles: Yeah, that's a pretty good summation. So, at its most basic level, a LIC or a Listed Investment Company is a collective investment. So, you take your $100 and you go and give it to a manager and then they are going to invest that $100 across a portfolio of assets on your behalf, and they have full discretion over what they invest in.

The point you bring up about the IPO, that's originally how a LIC is going to raise its money.

Hall: Initial public offering?

Miles: Initial public offering, exactly. So, the manager would go to the market and they would enlist the help of brokers and other market participants, very similar to an equity and all they would do is, they would offer investors the opportunity to invest at this IPO and raise capital that way. And then, after that point, investors can buy and sell units in the fund on the secondary market, so on the ASX.

Hall: Okay. So, there are some similarities, as I said, between ETFs which we'll get to. What the LICs invest in? What sort of things are people buying into?

Miles: It's a really good question. So, typically, in the Australian market, it's very biased towards equities and traditionally domestic equities. But we are seeing a bit of a renaissance in Listed Investment Companies and we are seeing global equity managers launch in some listed investment trusts and companies and there's a smattering of other asset classes, but also there's some fixed income, ones that have come to market and then some private debt. But I would say predominantly it's equities.

Hall: All right. So, again, similarity to ETFs and you get – people may use LICs for diversification purposes?

Miles: Yeah, absolutely. Yeah, there's some global equity listed investment companies that we think are a really good way to diversify from maybe away from for your core Aussie equity holdings, investing overseas.

Hall: We'll talk about some names a little later. Let's get into sort of the mechanics. How do LICs work, if I could put it so simply?

Miles: Yeah. So, after that sort of initial raising – so, you would invest – and maybe let's pick a number. They raise $100 million for example. After that point, those assets – the reason it's called a closed-end fund is because those assets are closed-in and for the manager, that's captive capital.

Hall: Yeah. I should have probably specified there and jumped in, because there's this term closed-end. An ETF is open, but a LIC is closed-end. That's probably what I should have said. What do we mean by closed-end exactly?

Miles: Yeah. So, this is really important distinction for you to understand. So, with that closed-end structure, you raise that money at the initial public offering. And say, you've got $100 million. And then if, you or I want to invest in that LIC after that initial public offering if we haven't participated, we're going to buy shares on the ASX of each other or of other market participants. Whereas with an ETF, again, it's still listed, it's still listed on the ASX. But what happens is, you would purchase, and they would create a unit for you. And so, the assets under management will grow in that circumstance.

Hall: And there's a bit of – you explained to me off camera – there's a bit more "volatility" in that there's a difference between how the assets in the listed company are performing in relation to the share price?

Miles: Yeah, absolutely. So, one of the really important things to consider if you are looking to invest in it, in a LIC, given its closed-end structure, is that the price that you're going to pay on the market, so if we call that the market price, can diverge and often quite meaningfully from what we call the net asset value and viewers may have heard it called NTA. And really, the best way to think about an asset value is just the value of those securities. So, if it's Aussie equities, what's the value of that basket of securities versus the price you are paying. And because market supply and demand dynamics, that can sometimes push that price to a premium if it's above NAV or at discount if it's below. And that's really important because you don't really want to be paying $1.20 for a dollar's worth of assets. So, that's something to really consider when you are investing in these things.

Hall: Okay. And in terms of how people can access them, is that similar to an ETF, how people just buy them as they would?

Miles: Yeah. So, they are trading on the ASX. So, if you have a brokerage account, you can do it that way and I think a lot of investors have found it quite convenient that they can – similar to their listed securities, their listed shares, they can transact in much the same way.

Hall: Okay. That's sort of all leading me to again repeat that they resemble exchange-traded funds in that way. What would you say to someone who said what's the key distinction between a LIC and an ETF, why should I bother looking at a LIC when I've got an ETF which seems to do the same thing?

Miles: Yeah. So, as we just talked about, the premium and discount is a big difference. So, when you buy into – or when you invest in an ETF, generally, they are issuing you that unit very close to the net asset value. So, typically, ETFs aren't going to be trading at these large premiums or discounts relative to the value of the assets whereas LICs are. So, for viewers, that's really important with the closed-end LICs. They need to consider that.

Other thing is that there can be some advantages to listed investment companies. Because the assets are closed, the portfolio manager doesn't have to worry about outflows so much. So, in an open-end structure, you can redeem your money probably every day. Most of the strategies that we look at, you can take your money out every day. So, that can create difficulties for an investment manager. If they take a very long-term time horizon on their investments, actually being in a closed-end structure can be helpful because they've got – they've locked that captive capital in and they don't have to worry about exiting a position at an inopportune time because a bunch of investors are looking to redeem. So, there are some advantages there.

Another one – and we won't get too deep into the tax side – but listed investment companies are incorporated as companies. So, they receive dividends and realized capital gains from the investments that they make, and they will be taxed at the company tax rate, which I think at the moment is 30% and then have a board similar to a company that can decide how much of those profits are distributed to shareholders. So, LICs can often – and some LICs have been very successful at delivering a really nice smooth income stream for investors which for some people at a particular point in their life is fantastic for them.

Hall: All right. Barbara touched on franking credits and dividends. Obviously, they are intertwined. We'll touch on that again. But I just want to pick you up – you mentioned managers. My understanding about an ETF is that – correct me if I'm wrong – there's less of an input from a manager. Is there someone pulling the levers every day on an ETF like a LIC or is that ETF more passive or how does that…?

Miles: It's kind of evolving actually. So, traditionally, lots of ETFs have been passively-managed.

Hall: By that you mean, you pick a bunch of stocks and then just leave them?

Miles: Yeah. Or you invest alongside an index. So, say, you take the ASX 200 and the ETF is going to do its best to replicate that as best as it can. But actually, there are some actively-managed ETFs coming to market as well. So, it's less of an active/passive debate anymore. And there's some LICs, some very old LICs that are quite inexpensive, and they take a very sort of long-term view and they don't trade that actively. But again, also there's some newer LICs that are far more active and are less cheap.

Hall: So, is it a generalization to say that LIC is being more actively-managed than an ETF?

Miles: Yeah, it's probably a little bit of a generalization. I think these structures are kind of evolving and the types of products coming to market are changing that.

Hall: All right. Let's talk about a little bit about risks. And I suppose a lot of people would be thinking, what about fees, how do they differ in terms of fees? Is more expensive than the other or…?

Miles: I mean, it really vary. So, there are some very, very inexpensive LICs. So, I think, AFIC, which is a very old LIC…

Hall: Yeah, Australian Foundation Investment Company.

Miles: That's it. So, I think, that was launched in 1930 – you're testing my memory – but 1936 and I think that charges in the region of 14 basis points, so 0.14%. So, that is quite comparable to passively-managed ETFs. On the other side of the coin, there are more expensive LICs that have what we'd described as more active fees, so fees close to 1% as opposed to 0.14%.

Hall: To pick you up on history there, you were saying that LICs have been around for a lot longer than ETFs, is that right?

Miles: Yeah, I think so.

Hall: Did ETFs evolved out of LICs or…?

Miles: I'm not entirely sure on that history. But LICs are an incredibly old structure. So, they are an old structure in Australia. Actually, if you go to the Northern Hemisphere in the U.K., there might be some that are maybe 200-years-old. They really are quite an old investment structure, whereas ETFs are probably in the last decades they've sort of come about.

Hall: Okay. Let's talk about some names. Who are the big players in the LIC sphere, who do you rate?

Miles: So, I'd say – so, AFIC is one that we rate. And really the things that we like about it is that sort of patient long-term low-cost approach. So, we think…

Hall: Yeah, I should have asked you first. What do you look for in a listed investment company?

Miles: So, how we assess these strategies is really the same across managed investments, exchange-traded funds, listed investment companies. We have a fundamental approach. So, we look at the people running the product. We look at the process, how they invest investors' money. We look at the parent, which is really important, the sort of the structure of the business. And that ties in with incentives and how are people incentivized. We look at the price as well. That's a very predictable thing to look. And we look at historic performance as well. But I would note that we put the lowest weight on that. So, that's the same regardless of the legal structure. But with LICs, there's a couple of other things that we do consider as well. So, corporate governance is one because there is that board and you want to make sure that that board has got the best interest of investors at heart.

Hall: Sure. I should have mentioned when I talked about risks. There's also – you were telling me there's systematic risks in that if something happens to the economy that affects what happens to your LIC, is that right?

Miles: It really depends on what you're invested in. But I think the big sort of buyer be aware for listed investment companies, it just is that premium and discount. And we take long-term views here and we don't want to try and market time, but investors should just be really aware that if it's trading at a premium or discount, that can really impact your performance. So, it could add performance if you buy something at a discount and that discount closes. But quite possibly, if you buy something at a premium and it turns into a discount, that can harm your returns as well. So, it's really difficult to say sort of what investors should do. But I would impress upon people just really think about that premium and discount and be prepared that these premiums and discounts can persist for longer than you might think, because there are inefficiencies in the market. So, yeah, I would really impress upon people just to really think about that when they are investing.

Hall: Let's get back to names. You mentioned AFIC. Who else do you like?

Miles: So, maybe shifting gears slightly to the global equity side, so we do like – Platinum have a LIC as well. So, it mirrors quite closely their unlisted product and we just think Platinum has been investing money internationally for a very, very long time ago, very experienced team and lots of good investors. And even with Kerr Neilson stepping back slightly, he's still involved. There's some great people at Platinum. And we just think the way they invest and the way that they find value – I suppose off the beaten track, they've had success in emerging markets. We just think that's an attractive investment there.

Magellan as well. Magellan has launched a LIT.

Hall: Listed Investment Trust?

Miles: Listed Investment Trust. So, that's incorporated as a trust as opposed to a company. And Magellan launched that a couple of years ago. I think it might have been at the end of 2017 and that's another strategy that we're very familiar with. We've known Hamish Douglass and that team for a very long time. We really like the way they invest. They invest differently. It's more – it tends to be developed markets; it tends to be quite concentrated and there's a real sort of quality focus on the stocks that they invest in. But they are too that sort of catch our eye.

Hall: Hamish Douglass incidentally is going to be speaking at the Morningstar Investment Conference which is next Thursday in Sydney at the International Convention Center.

I'm Lex Hall for Morningstar. If you're just joining us, I'm with Andrew Miles. He is an analyst with Morningstar. We're talking about Listed Investment Companies. How they differ to exchange-traded funds, how they work, how you can get into them. We've got a few questions, Andrew, and I'm afraid they are pretty prickly actually.

We'll start with Tony. Tony asks can you please discuss the differences between LICs and ETFs? We've gone over the pros and cons between the two. Anything that I've missed out that we should add? I think you've talked…

Miles: I think it's just that difference between the closed-end and open-end structure. I would just reiterate that both can be – there's sort of active and less active versions of both. So, we can't quite make that distinction. But I think the biggest one is that premium and discount difference between the two. But they are both listed on an exchange, so you can transact that way.

Hall: I should also remind you. You can go back to Morningstar.com.au and see the webinar that we did earlier with Alex Prineas about exchange-traded funds with Emma Rapaport it's very insightful there and it will give you a good counterpoint to what we are talking about today.

Barbara, who I touched on earlier, who was terrified about franking credits asks, "I'm very interested in listed investment trusts, which you just talked about, particularly because of Bill Shorten's promise now to cut franking credits, how do dividends operate in LICs?

Miles: So, that's a really good question and that is something that is quite notable about the LIC structure. So, as I said, it's incorporated as a company. So, when that LIC receives income from – let's keep it simple – income from the shares and realized capital gains, they don't have to pass all of those through. So, they would hold those, they will pay a company tax rate, so 30%, and they can keep some of those profits in reserve and then the Board can decide how much to pay out. Very similar to an equity, what an equity would do with its profits.

So, for certain investors you're going to be taxed at – the company is going to be taxed at 30% and then it's going to be passed through and there may be some tax benefits there if you're, as I say, a 0% tax liability.

Hall: Do people look at LICs because of dividends, franking credits in particular, or…?

Miles: I think that has been one of the reasons that LICs have been quite popular. And I think it's because with interest rates where they are globally, bank deposits where they are, the need for yield and the need for sort of nice stable income is something, I think, investors have really been interested in and really need. And there's lots of LICs that have done a really good job of taking those profits, paying some out and just trying to ensure a nice, smooth income stream for investors. And so, if people are in retirement, that nice smooth income stream can help them budget and help them support their lifestyle.

Hall: Okay. John asks, "I have $500,000 to place to earn better interest than is available from the banks. I'm looking at the Australian Foundation Investment Company, AFIC and Argo, another name, to cover Australian shares, but also ETFs to broaden my risk spread by placing some funds in Australian-listed ETFs to get exposure to commercial property in Australia and overseas. And he asks "Is there an Australian-listed LIC that will cover the alternatives to Aussie shares that he mentions?

Miles: Yeah. So, I think, we don't cover the whole market. So, there's maybe a 100 roughly LICs on the market. We cover a fraction of that. I'm probably not in a best place to give personal advice, but I would say there's – as I mentioned those global equity LICs that potentially could be quite attractive. But a lot of our research is available…

Hall: Sure. Yeah. I was just going – we're happy to answer your questions offline, Morningstar.com.au, you can go there for all the research. We'll get back to that in a second.

Basil Ladyman writes from WA. Good day, Basil. I have a couple of queries please. To allow us (SMSF investors) an opportunity to diversify our risk are there any LICs that invest in unlisted assets such as infrastructure and property?

Miles: So, there's nothing that we have formal coverage of. So, most of the LICs are invested in Australian shares, global shares. There's a few in the fixed income space as well, and I think there are more things coming to market. So, I think, off the top of my head – and I can double check this – I think there might be an alternatives product listed from a company called Blue Sky. But we've never covered it. We never really got comfortable with that organization and people have probably read in the press some of the issues that Blue Sky, the management company is experiencing. So, I would say that is listed, but certainly seek financial advice before you invest in that or look at that and it's probably not something that we would ever cover.

Hall: Okay. All right.

Miles: But I guess the point is that there's – choice is improving and there's these things coming to market. So, there's more asset classes becoming available.

Hall: Okay. Part two of Basil's question. He says in regard to capital reserves, the dividend is paid out topped up by profits. Is there a recognized ratio that is used to determine what a healthy reserve fund should look like? Does having a larger reserve fund meaning that a LIC is more conservative?

Miles: That's a good question. I mean, when we sort of assess these things, we don't have a hard and fast rule about what is a suitable reserve or make any predictions about what the reserve will look like. I think the thing just to remember is that if you're investing for income how that they sort of think about paying out that income is really important. But in times of real market stress, that reserve could be depleted really quickly. So, I think, yeah, it's a good point, but we don't make judgements on the attractiveness of a LIC based on the reserve that they have.

Hall: Okay. You're with me Lex Hall from Morningstar and Andrew Miles, analyst from Morningstar. We're talking about Listed Investment Companies. Because it's Facebook live, we are getting some live questions. We thank you for that. Please send in more. We'll answer them here and also offline as best we can. We got a question here. I'm not quite sure who it's from, but it says, what is – and we mentioned this – what is different about a Listed Investment Trust.

Miles: Yeah. There's just so many acronyms in this space. But Listed Investment Trust is again closed-end. So, you can – going back to what I was earlier talking about, you can get that premium discount, but the trust means that – compared to the company means the trust is going to pass through those distributions. The company is going to tax them at the company tax rate and have a bit more discretion. So, the Magellan vehicle that I mentioned earlier is a listed investment trust. And I wouldn't be surprised if there were more listed investment trusts coming to market. Magellan were incredibly successful with the product that they brought to market.

Hall: Okay. And another question has just come in. Please explain how some LICs can pass on capital gains as a dividend? We sort of touched on that. What is the benefit?

Miles: Yeah. So, again, I think it's the flexibility that they have. So, with that income and that realized capital gains that they get from their investments, often they will have a target for distributions, and it is just helpful that they have that flexibility. And similar to Basil's question, they've got that reserve. So, they have a particularly fantastic year investment-wise and they collect lots of income and they make successful decisions and they got lots of capital gains and they can hold them in reserve. They can hopefully smooth that out for investors. But I would – just as sort of a warning – I would say to people that on the tax side it's really important to seek tax advice and speak to your financial advisor, speak to an accountant just to understand your own situation.

Hall: Sure. That question was from (Venti Settembre). So, thank you (Venti) for question and all the questions today. Please send in more comments. We'll answer them offline. We've been going for quite a while now. I think that's probably it. I'm getting a word my producers here who are frantically waiving their hands. So, it's a lot to take in and a lot to take in anyway, isn't it?

Miles: Yeah, absolutely. And there's some research that maybe we can share with them, with some of the viewers today as well.

Hall: Yeah. Okay. Of course, thank you all for watching and for sending in the questions, they were really good. There's obviously a lot of people out there who are not only interested in LICs but know a lot about them. We'd like you to go and visit Morningstar.com.au where you'll find all the latest news and all the company research and investment ideas. You can also check out our portfolio creation tools which are very powerful in helping you to select stocks, funds, evaluate them, tap into some of Andrew's insights. If you like, sign up for a trial. It's free. You can also sign up for a premium subscription which is about $33 a month and premium subscribers can also visit our new website which is fantastic which Mark and Steph outlined a couple of weeks ago which is so much more powerful now because it allows you to look at not only Australian stocks and funds but also the investment world at large. So maybe you could tap in any stock you want really and see what people think it's worth and what the market is paying for it. So, it's quite fascinating. So, that's premium.morningstar.com.au and you can drop us a line on Facebook, obviously. And don't forget Twitter. Our handle is @MstarAus.

Andrew, thanks very much for your insights.

Miles: Thanks, Lex.

Hall: I'm Lex Hall for Morningstar. Thanks for watching.

This report appeared on www.morningstar.com.au 2019 Morningstar Australasia Pty Limited

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